Economic Indicators on the Move

The US economy continues to grow at an annualized pace of 1 to 2 percent. Although US gross domestic product (GDP) expanded by 2.9 percent in the third quarter, much of this acceleration stemmed primarily from a build in inventories and a one-off surge in soybean exports.

Many commentators hailed the October employment data as a sign of strength, but these figures exhibit scant evidence of a change in trend.

The headline unemployment rate came in at 4.9 percent and hasn’t exceeded 5.5 percent February 2015. Private payrolls increased by 142,000 in October, bringing the 12-month moving average to 179,000—down from 250,000 net new jobs created in early 2015. The six-month moving average stands at 153,000 new additions to private payrolls, down from more than 200,000 at the start of the year.

But average hourly earnings jumped 2.8 percent from year-ago levels—the largest increase since 2009. Wage inflation appears to have broken out from the annualized rate of less than 2.25 percent that persisted after the Great Recession.

A stable jobless rate and declining gains in monthly payroll data suggest that the economy could be nearing full employment, a point underscored by upward pressure on wages and anecdotal survey information about employers struggling to hire qualified applicants.

An extended period of lackluster GDP growth suggests that the US economy has a lower ceiling than in the past. In other words, an economic expansion of more than 1.5 to 2 percent would tend to increase inflationary pressure and overheat the economy. Historically, the potential growth rate for US GDP has hovered between 3 and 4 percent.

A lower speed limit for the economy makes it tough for corporations to generate top-line growth, which helps to explain why cost-cutting and share buybacks have driven earnings in recent years. Corporate investment and capital expenditures have also disappointed.

The economy’s lower speed limit also suggests that monetary policy may be much tighter than implied by nominal interest rates. In this environment, the economy will struggle to withstand a normal cycle of hiking interest rates.

Our bet against financial stocks was based on our expectation for interest rates and economic growth to remain lower for longer. And the S&P 500 Financials Index had underperformed the broader US market, at least through the end of October.

But the combination of President-elect Donald Trump and a Republican-controlled House and Senate puts our original economic outlook in doubt. The incoming administration will seek to make good on some of its campaign promises early in Trump’s term. Senate Democrats can block some legislation through a filibuster, unless Republicans can cultivate support across the aisle.

However, Senate Republicans could use a process known as reconciliation to pass high-priority legislation and avoid a filibuster with a simple majority. President Trump can also issue executive orders without Congressional approval or review.

The president-elect’s primary initiatives likely would include:

Tax cuts for individuals and businesses;

Repealing unpopular parts of the Affordable Care Act;

Allowing companies to repatriate cash held overseas at a less punitive tax rate;

Significant infrastructure spending; and

Reduced regulation of many industries, including banking and energy.

A plan for increased infrastructure spending might receive bipartisan support in Congress. Taken together, these initiatives would result in significant fiscal stimulus and a more business-friendly regulatory and political environment.

In this scenario, US economic growth could accelerate and inflationary pressure could kick in, boosting corporate earnings and giving the Federal Reserve the capacity to hike interest rates at a faster-than-expected pace over the next 12 to 24 months.

The market has started to price in this scenario, with investors bidding up stocks and rotating into cyclical industries that would benefit from increased spending on the military and infrastructure.

Meanwhile, inflation expectations have also increased. The five-year break-even rate of inflation—the yield spread between government bonds and Treasury inflation-protected securities (TIP)—stands at roughly 1.75 percent, the highest level in two years and up from less than 1.3 percent this summer. Measures of longer-term inflation expectations have also jumped.

The Federal Reserve has contended with deflationary pressures and a slower rate of potential economic growth, challenges that have made it difficult to hike interest rates.

Higher inflation and stronger GDP growth should enable the US central bank to hike interest rates without damaging the economy or triggering a selloff in the stock market.

Bottom Line: The prospect of accelerating economic growth, higher interest rates and reduce regulation should give financial stocks a boost. For Capitalist Times Premium subscribers, the recent issue details specific opportunities and position our two model portfolios for growth while protecting downside. If you aren’t a subscriber, become one today.

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